China’s Markets: Riding The Internationalisation Of The Financial Markets
China’s journey of liberalisation has continued to accelerate with its stock, bond and currency markets opening up further. In 2018 there were more government announcements to ease restrictions on foreign access to the domestic financial market. The increasing inclusion of both onshore equities and bonds in the major international indices is a milestone for the internationalisation of China’s capital markets, which will take a hundred billion (or even a trillion) dollars of inflows to the domestic market in the medium to long term.
The A-share market, onshore bond market and currency market (RMB) are the three financial channels that China has been focusing on to achieve internationalisation.
Recommended investment ideas include the following:
This is a multi-year investment theme. The recommended investment horizon is more than 1 year.
Inclusion in major international indices are driving long-term flows
Last year, more index companies made announcements of the initial or increasing inclusion of China’s onshore equities and bonds in their major indices, thanks to the robustness of Stock Connect and Bond Connect, an improvement in market accessibility (such as quadrupling the daily limit in Stock Connect and a visible decline in trading suspensions), as well as reform measures by the Beijing government.
1. Increasing MSCI inclusion of China A-shares:
Following a successful 5% China A-share inclusion in 2018, MSCI recommended increasing the inclusion factor of China A-share large caps to 20% in 2019 and broadening eligible A-shares to ChiNext and midcap stocks within this two-year period. Upon the 20% inclusion by 2020, the weighting of China A-shares in the MSCI China Index will increase from 2.3% currently to 10.8%; from 0.7% to 3.4% in the MSCI EM Index; from 0.9% to 4.0% in the MSCI Asia ex-Japan Index; and from 0.1% to 0.4% in the MSCI AC World Index.
2. Initial FTSE inclusion of China A-shares:
The FTSE (Financial Times Stock Exchange) announced that it would on-board China A-shares with a 25% inclusion factor within these two years. After completion by 2020, China A-shares will represent about 5.9% of the FTSE All Cap EM Index and 0.6% of the FTSE All World All Cap Index.
Market expectations of the combined MSCI and FTSE inclusion-related flows from both passive and active funds are estimated to reach approximately USD 100 billion by the end of 2020. The MSCI inclusion has increased foreign investors’ focus on the domestic equity market, while the upcoming onshore bond inclusion should have a much bigger impact.
3. Initial Bloomberg Barclays Index inclusion of onshore bonds:
Bloomberg announced in March 2018 the inclusion of China onshore government and policy bank bonds in their Bloomberg Barclays Global Aggregate Index, which will be phased in over 20 months starting from April 2019. By November 2020, the index is expected to include 386 local currency China bonds, accounting for a 5.5% slice of the USD 54 trillion index. This is a big step towards the global recognition of China’s USD 12 trillion bond market.
If two other major global bond benchmarks—namely the JP Morgan Government Bond Index -Emerging Markets and the Citi World Government Bond Index—follow suit, this would be a game changer for the Chinese bond market, not to mention the untapped potential of China’s domestic corporate bond market.
Internationalisation of the RMB
Since the inclusion of the RMB as a reserve currency in the new Special Drawing Right (SDR) valuation basket (launched by the IMF in 2016), cross-border RMB settlements have been few and far between but the trend is picking up. China’s Belt and Road Initiative will be a powerful force in propelling the RMB to the global stage amid a rise in cross-border trades and investments in RMB.
Key beneficiaries of this trend are financial institutions involved in the settlement process, such as banks with regional and/or broad EM networks. In addition, certain other stock exchanges are bound to reap the benefits of the secondary listing of an increasing number of China’s financial products, denominated in RMB.
Foreign investors’ participation in the onshore financial market will keep growing from a still low base. With Beijing continuing to improve market access, foster greater transparency and reform its regulatory and legal framework, all this will drive an increasing inclusion in major global indices, and gradually bring massive inflows onto the third-largest equity market (Shanghai and Shenzhen exchanges combined) and the third-largest bond market in the world in the long run.
The key risks of investing in this theme are the following:
1. China’s growth slows much more than expected (“hard landing” scenario) which hurts sentiment in any China-related investment.
2. A new phase of US-China trade tensions.
3. RMB shows a disorderly depreciation.
4. China’s authorities show signs of a pause or reverse the direction of capital market liberalisation.
5. No further inclusion of onshore bonds and equities in major global indices as numerous foreign restrictions are still in place.